The idea of fuss-free income beckons many people into owning and managing rental properties, such as apartments, duplexes, guest homes, and even large houses. From the outside looking in, it appears that property owners simply sit back and collect rent checks on the first of each month, with little additional work. On paper, it’s a lazy (or savvy) worker’s dream come true.
Unfortunately, the paychecks associated with rental properties aren’t quite so easy to come by. Although rental properties can certainly generate sizable income, it’s important to remember that owning and managing a property is still a job. Before you dive into the world of income properties, take some time to seriously consider the pros and cons of such an arrangement so you can make sure your strengths and weaknesses match up appropriately with the benefits and drawbacks of the job.
Advantages of Managing a Rental Property
1. A Monthly Paycheck
The monthly paychecks you can earn for owning and managing a rental property is one of the few occasions in which you can sometimes collect income for doing almost nothing. When the property is in good shape and your tenant is responsible, you can collect rent checks to help offset the cost of your mortgage and other expenses of keeping up the property. If the mortgage is less than what you collect for rent, you may find yourself in the happy situation of having a surplus each month.
However, keep in mind that you need to set aside money for home improvements and repairs, future vacancies, and taxes. The amount you set aside depends on your tax bracket, the condition of the home, and your projections for vacancies and tenant turnover.
But even if you take a loss on the property (expenses are greater than income) each month, it may still be worth your investment. That depends on how much you expect the property to appreciate during the time you intend to hold it, how much you expect the rental market to improve during that time, and the impact the loss will have on your taxes.
Roofstock, which is a marketplace for turnkey investment properties, has a very thorough report of each properties financials to help you understand potential cash flow each month.
2. Equity as an Investment
Like any investment, owning and managing rental property comes with risks. But for those who take the risk, there is the potential for a significant reward.
Two great things can happen: First, the property may appreciate in value over time, and second, your equity investment in the property is offset and may be completely covered by the amount of money you earn. Plus, you can get a substantial tax break on your investment since you can write off interest payments on your mortgage, in addition to all your expenses.
If these two things occur, then you may be able to collect a substantial check when you sell or refinance the property with Figure.com. Just make sure to set aside a portion of your projected take-home for capital gains taxes when you sell, as well as money to cover the fees associated with either refinancing or selling the property. Unlike a primary residence, any money you make on the sale of your rental – less expenses – is taxable.
3. An Alternative to Selling
Rental properties can provide a nice alternative to selling if the market is in a slump. For instance, it’s increasingly difficult for potential buyers to find financing, so there may not be enough demand for your property to generate the sale value that it is worth. If this is the case for a property you own, it may be wise to rent it until the market improves. By renting out the property before selling it, you can build equity while riding out a bad market.
Additionally, a huge benefit of renting out your property in a down market is that you may be able to write off some of the loss on the home when it comes time to sell. This is best done if you anticipate that the property will depreciate further in value once you begin to rent it. This savvy move can ease the pain of selling your home at a loss because, as a business property, you’re allowed to claim a portion of that loss as a deduction against your income, which is especially helpful if you’re in a higher tax bracket. You can write off up to $25,000 in losses.
4. Additional Tax Benefits
As a landlord, you can write off a huge number of expenses related to owning and managing your property. Landlords can write off mortgage interest, depreciation, repairs, travel, and insurance costs related to the property. And like any self-employed individual, a landlord can also write off home office expenses, legal and accounting services, and other expenses related to running a business.
These write-offs can translate into money back in your pocket at the end of the year. And, in many cases, unlike a self-employed person, you won’t claim your income on Schedule C and you won’t be required to pay self-employment tax, in addition to income tax.
By owning and managing a property, you can be your own boss. Granted, you may not be able to make ends meet with the income generated from just one property, but there are many savvy investors who turn rental income into their livelihood. These investors usually own and manage a portfolio of properties, which is a lot of work. The trade-off, of course, is that they are able to invest, maintain, and leverage according to their wishes and schedule.
Disadvantages of Owning a Rental Property
Rental income for property owners and managers can be a wonderful investment and source of income. However, it is more complicated than just cashing in on your tenants’ rent checks.
1. Tenants Can Be Awful
Renters have few reasons to meticulously care for a property. Often, in a best-case scenario, a tenant will leave the place a little dirty when he or she moves out. You still need to repaint and complete basic homeowner maintenance.
Unfortunately, tenants who are either slobs or vindictive over perceived slights have been known to completely ransack a property, knowing full well that a measly $500 security deposit is worth their slavishness. In these instances, you may have to shell out thousands of dollars to return the property to an acceptable condition for successive tenants.
Furthermore, tenants sometimes just stop paying their rent, knowing that they can likely get away with it for awhile due to your costs of taking them to court for an eviction. Either way, awful tenants can set you back tens of thousands of dollars – and can cause countless headaches.
2. The Investment Requires Capital
Beyond the capital required for a down payment to purchase a property, you need to have liquid capital to manage your property. For instance, you may need thousands of dollars to repair a property that is demolished by an awful tenant. You may need hundreds of dollars to take a tenant to eviction court. And lest you think that screening for a decent tenant reduces the amount of capital needed on hand, unexpected home repairs are often costly, and you’re legally required as a landlord to deal with property problems quickly and sufficiently.
For instance, you need hundreds of dollars on hand to replace a busted water heater, and possibly thousands of dollars to replace a leaky roof. You also need additional insurance coverage if you’re renting out your home, since homeowners insurance only applies to owner-occupied properties.
3. Potential Legal Consequences
Speaking of legal problems, the law is on your tenant’s side if you fail to make necessary repairs due to your time or money constraints. According to Nolo, your tenant can withhold rent or even walk out on a lease without punishment if you don’t properly take care of business. Moreover, if the tenant’s lease isn’t airtight, then you may have little recourse if your tenant damages property or does not satisfactorily pay rent.
Be sure to have a lawyer experienced in rental real estate review the specifics of your lease. And remember that if you don’t check your insurance policies for adequate liability coverage, then your tenant can take you to court if he or she or guests are injured on the property.
4. Time-Consuming Efforts
Obviously, unexpected repairs can take time to troubleshoot. However, the whole process of rental property ownership and management takes time.
You have to account for the time and energy needed to find a high-quality tenant through applications, interviews, and credit reports. You also have to remain on top of your tenant’s deposits, rent checks, inquiries, and needs. Your tenant is paying you not only for a place to stay, but also for service on the property. All of this takes time and know-how.
You can’t just assume that your income will pour in without a substantial number of hours set aside for property management. This is especially problematic if you’re trying to hold down a conventional full-time job too. In this instance, you can outsource the day-to-day business of property management to a specialized property management firm, but this further reduces your bottom line by 8% to 10% or more depending on how much you’re earning. Before you get started, it’s a good idea to speak with a few local property management companies to get an idea of what services they offer and how they charge for them.
5. The Bottom Line Can Bite Back
Like all investments, there is risk associated with owning and managing a rental property. Sometimes, the markets don’t behave the way you’d like, such as when a property depreciates rather than appreciates in value. Other times, problems befall a property, such as a string of bad tenants or expensive repairs (which is especially devastating if you haven’t set aside enough liquid capital to deal with the problems). You may have difficulty filling vacancies or earning a return that’s worth the time you’ve put into it. You can guard against setbacks by diversifying your portfolio of properties, so your financial future isn’t entirely tied up in one income property.
Finally, remember that the government will come knocking for its fair share of your income. Make sure to carefully document your income and expenses so the government can’t take more than it is due. If you have any tax-related questions about the use of your property, its income, or its expenses, check with your accountant to make sure you’re not surprised by any hidden rules at the end of the year.
6. Converting a Primary Residence to a Part-Time Rental
If you’re not careful, the small print on your rental property ambitions can come back to haunt you. Take, for instance, the increasingly popular vacation property rental. Tax laws don’t just allow you and your family to exit the premises for a few weeks a year to obtain a little extra income and write-offs. In this scenario, you’re welcome to rent out your home for the extra income, but you probably won’t be able to take any additional deductions.
Any property you own is still considered a primary residence if you and your family occupy the home for more than 14 days or more than 10% of the time it is occupied by renters, whichever is greater. If the property is still counted as a primary residence, even if you’ve converted it into a vacation property, you cannot deduct your expenses against your rental income when it comes time for taxes. (However, because it’s your primary residence, you can still deduct mortgage interest, in many cases.) If your motivation is to benefit from the deductions associated with renting your home, talk to your accountant before you make any bold moves with converting your property into a rental so that you won’t be shocked at tax time.
If renting property sounds appealing to you, and in-depth property management is beyond your skill-set, interests, or scheduling limitations, consider hiring a property management company. In the ideal scenario, you can generate income and/or equity from rent, but someone else remains in charge of the day-to-day property upkeep, collections, and even finding new tenants. It’s a good idea to interview more than one local property manager to get a sense of the services that company provides and whether their expense is worth it.
Have you ever experienced a major drawback associated with rental properties?